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Beware “Sunk-cost” Thinking in Financial Decision-Making

Late last year, while participating in a Board meeting on which I served for a client, I was reminded of the old adage “throwing good money after bad”, and dismayed by how costly it could potentially be for a company.

Although a familiar strategy for private and corporate investors, looking to “average-down” and lower their ACB for falling investment values for public securities, this methodology can cause added challenges when applied in the boardroom,  to capital or project spending.

When large projects overrun their schedules and budgets, or the original economic case no longer holds, the simple answer should NOT be to simply keep investing to complete them. Large-scale IT projects often fall into this category, an example of which was the London Stock Exchange’s ill-fated TAURUS project that suffered from poor definition, scope creep and numerous cost overruns.

Why do executives responsible for making strategic investment decisions so often fall into the sunk-cost trap? Loss aversion and anchoring. Many executives believe that it is better to spend an additional $5.0 million to complete an ill-conceived or uneconomical $55.0 million project, that would ultimately serve little benefit, rather than write off $50.0 million.

Another reason is based on anchoring or framing: once the mind has been anchored at $50.0 million, an additional $5.0 million really doesn’t seem so bad. Anchoring (framing) can indeed be a powerful tool for strategists, especially in negotiations to sell a company or product – however it is a double-edged sword.

To avoid falling into the “sunk-cost” trap in financial decision making, you should consider the following:

1. Always apply the full rigor of investment analysis to incremental investments, looking only at incremental prospective costs and revenues.

2. Have an independent advisory panel or working group review the original project overview and financial analysis to validate the ongoing viability and   economic value of the project.

3. Be prepared to kill strategic experiments early.

4. Use “gated funding” for strategic investments, much as pharmaceutical companies do for drug development – release follow-on funding only once strategic experiments have met previously agreed milestones and targets.

So, how did my experience last November work out? We figured it out, but for my next article in this series, I’ll comment on the “False consensus” effect.